RETIREMENT ISN’T JUST about reaching some magic savings number. You also need a strategy for turning that pile of savings into a reliable stream of retirement income that’ll last for the rest of your life.
In academic lingo, it’s about changing from accumulation to decumulation—and it’s a topic that my husband Jim and I grapple with, as we figure out how best to cover our retirement expenses. There are three common strategies:
Systematic withdrawals. This is the best-known strategy. The goal is to generate a steady, inflation-adjusted flow of income from a volatile investment portfolio. It’s where the famous 4% withdrawal rate comes from.
The notion is that, over a 30-year retirement, the most you can safely spend each year from a balanced portfolio of stocks and bonds is roughly 4% of your nest egg’s starting value. That 4% is the sum withdrawn in the first year of retirement, with the dollar amount withdrawn in subsequent years increasing with inflation. If you use the 4% rule, U.S. market history suggests you shouldn’t run out of money, even if we get high inflation and terrible market returns.
Time-based buckets. This approach sets up separate pools of investments for different time periods in retirement. You might invest conservatively with high-quality bonds and cash investments in the near-term time bucket, take on moderate risk by investing in bonds and some stocks for the next bucket, and perhaps be even more aggressive by investing exclusively in stocks with the long-term bucket.
For example, upon retirement at age 65, a couple might divide their retirement portfolio into three buckets, one for ages 65 to 74, one for 75 to 84, and the third for 85 and beyond.
Income floor. With this strategy, expenses are classified as essential or discretionary. Income from bonds, cash investments, Social Security, pensions and income annuities are used to create a flow of reliable income to cover all essential expenses. Meanwhile, discretionary expenses are funded by a mix of stocks and other riskier investments.
Which approach is best? All three strategies have benefits and drawbacks.
Because systematic withdrawals involve drawing on a mix of stocks and bonds, it gives retirees the opportunity to increase their wealth if markets perform well, but it also carries sequence-of-return risk—the risk of poor market returns early in retirement, which can cause retirees to deplete their portfolio quickly.
The bucket approach appeals to our fondness for so-called mental accounting. Retirees may find they’re comfortable investing the long-term bucket aggressively, because they know they have the other two buckets to cover nearer-term expenses. The biggest drawback: It’s a complicated strategy to execute. When do you refill the near-term buckets? If retirees let the short-term bucket get too depleted, the overall portfolio’s allocation to stocks will increase, creating a riskier portfolio as retirees get older.
Meanwhile, the income floor appeals to retirees who want greater security. The downside: To buy that security, you’ll likely need a large investment in bonds and income annuities—and that means giving up the opportunity to increase wealth if markets perform well.
I personally like the income floor strategy. I would sleep better at night knowing that, no matter what happens in the financial markets, Jim and I will still have a roof over our heads and food on the table. But because we retired in our 50s, it’s expensive to buy annuities. We’re relatively young, plus interest rates are low. So, for now, our decumulation strategy is based on time-based buckets.
But our eventual goal is to create an income floor. At age 70, we’ll both claim Social Security, which will help cover much of our essential expenses. If we need more regular money every month to cover those expenses, we’ll then look to buy income annuities.
In 2017, Jiab Wasserman left her job as a financial analyst at a large bank and is now semi-retired. Her previous articles include Time Well Spent, Those Millennials and Cutting Corners. Jiab and her husband Jim, who also writes for HumbleDollar, currently live in Granada, Spain. They blog about downshifting, personal finance and other aspects of retirement—as well as about their experience relocating to another country—at YourThirdLife.com.